Swaption

A swaption is an over-the-counter contract that allows but does not obligate the buyer to enter into an interest rate swap deal at a predetermined strike rate and future date. The phrase is a portmanteau of swap and option, enabling traders to reduce interest rate risk by swapping cash flows or liabilities.

This contract, also called the swap option, permits investors to perform different swaps in exchange for premiums. However, it does not obligate buyers to enter into a pre-decided swap agreement. Aside from being non-standardized, this option guarantees a maximum fixed interest rate and gives the customer flexibility and protection.

• A swaption contract gives buyers the right to enter into an interest rate swap in exchange for a premium, but it is not obligatory.
• It is traded outside the stock exchange at a predetermined strike rate and future date, and the buyer pays a premium upfront to the issuer of the swap agreement.
• A swap option agreement is non-standardized and provides the buyer with freedom and protection while guaranteeing a maximum fixed interest rate.
• The interest rate swap is categorized as Payer and Receiver. It can be executed in three ways – European, American, and Bermudan and physically resolved or cash-paid at expiry.

A swaption is an interest rate swap contract between a buyer and a seller (issuer). It is one of the best backup strategies for traders who want protection against risks of market interest rate swings that could occur at any moment in the future.

It also implies that the buyer will be offered a maximum fixed interest rate on future borrowings. As a result, if the rate rises above the predetermined terms at the contract expiry, the buyer can exercise the swap and stay protected from losses. On the other hand, if the rate does not increase in the future, the buyer can borrow at lower market rates, avoid exercising the swap and sell it for monetary gains.

• A swaption is traded outside the stock exchange or open market.
• It usually occurs in the U.S. dollar, sterling, euro, and Japanese yen.
• The buyer and the seller must predetermine the swap option price (premium) and expiry date.
• The premium allows the trader to execute the swap option at a fixed or floating rate and notional amounts.
• The buyer must pay a premium to the issuer of the swap deal.
• Large corporations, investment and commercial banks, financial institutions, and hedge funds are the main participants in the swap option.
• Investors use the contract as a backup plan if their main operations and financial arrangements are exposed to interest rate risk.
• The options contract can be settled in two ways:

1. Cash Settlement - When the seller pays the buyer the current market price for the underlying swap
2. Swap Settlement - Two parties swap according to the agreement's predetermined terms when choosing a swap option.

The terms and conditions of different swaption contracts vary. Hence, there are three categories in which they can be executed:

1. European Swaption: The buyer can enter and exercise the swap option at expiry.
2. American Swaption: The buyer can exercise the swap option at any time between the origination and expiration periods.
3. Bermudan Swaption: The buyer can enter and exercise the swap option on multiple specified dates.

The European swaption form of execution is generally favored due to its simple terms and one exercise date. The other two are more complicated in terms of execution.

The two common types of swaption are:

#1 - Put or Payer Swaption

This form of swap option gives purchasers the option of entering into a swap agreement in which they pay a fixed swap or strike rate (non-changeable) while receiving a floating (variable) swap rate. Firms frequently choose this option to protect themselves from interest rate risk if interest rates rise in the future.

#2 - Call or Receiver Swaption

Here, buyers have the opportunity, but not the obligation, to participate in a swap option contract in which they obtain a fixed swap rate while paying the variable swap rate. Mortgage lenders typically choose this option to protect themselves from decreased interest rates, which would result in early mortgage prepayment.

Let us consider the following swaption examples to understand the concept better:

Example #1

Mary entered into a swap option contract to make sure she does not face any interest rate risk in the future. The issuer, John, prepared the agreement and specified a predetermined rate of 8% with the expiration date mentioned. Contrary to what Mary expected, the interest rate fluctuated but remained in her favor on the date of contract expiry.

As a result, Mary did not bother to execute the swap option anymore. However, she could do so as the contract gave her the right to enter into an agreement if needed but did not make it an obligation in any manner.

Example #2

Dynex Capital, an American real estate investment trust, released its fourth-quarter financial report for 2020, announcing a total economic return of 15.2% and total shareholder returns of 17%. However, the corporation invested $750 million in interest rate swaption to get greater returns and ensure that interest rate risk does not impair the entity's financial success over time. Additionally, this aided the corporation in replacing US Treasury options that had expired or been terminated.

Swaption finds relevance in different financial decisions that traders make to maximize the return on their investments. Speculators and hedgers, in particular, benefit the most from such contracts.

Speculators anticipate the interest rate risk and seek to protect themselves with a swap option if required in the future.

On the other hand, hedgers pay a premium for the swap option and use it as a backup plan to cover their losses in the event of significant market changes. For example, the interest rate risk on bonds.

For instance, Jed takes up two loans, accounting for $100 million, maturing in two years. But he is unsure how the market will turn out in the next couple of years. Thus, he enters a swap option to hedge his expected refinancing plans against an adverse increase in the 10-year rates.

Besides, there are other reasons to execute a swap option deal, such as:

• Restructuring existing financial positions
• Altering an investment portfolio
• Covering losses on a rollover of an existing loan agreement
• Facing uncertainty regarding the borrowing timing or need
• Getting protection from unpredictable interest rate movements
• Having future funding requirements that demand flexibility

Let us look at the benefits and drawbacks of swaption through the below-mentioned table:

This has been a Guide to Swaption and its meaning. Here we discuss how swap options work along with features, types, examples and uses. You may also learn more about financing from the following articles -

• Options in Finance
• Credit Default Swap
• Currency Swap